Don't Pay Alpha Fees for Beta Performance

Mallory Horejs: Hello. My name is Mallory Horejs, and I'm here at the 2011, Morningstar ETF Invest conference. I have with me Adam Patti, the CEO and founder of Index IQ, a firm that specializes in innovative index-based investment strategies.

Adam, thanks so much for joining us today.

Adam Patti: Thanks for having me.

Horejs: So, Index IQ is particularly well-known in the liquid alternative space for its hedge fund-replication products. I was hoping you could explain to our viewers how a strategy like this works and how it's differs from actually investing in a hedge fund?

Patti: Sure. These are very exciting products, and certainly in today's market volatility underscores the need for them in a well-diversified portfolio. What hedge fund replication is, as succinctly I can be, there are 10,000 hedge funds today. There are as many hedge funds out there as mutual funds. As we know, 85% or so of actively managed mutual fund managers underperform their benchmarks every year. So, this goes to show that the same should be going on in the hedge market, which it is. Not everyone is getting into the best hedge funds. It's just mathematically impossible. Somebody is getting into the ones that underperform.

So, what the academics proved in the '90s is that when you look at hedge fund performance you can identify their asset class exposures using a very simple style analysis. We don't care what an individual hedge fund manager necessarily is buying or selling. We care about what the broad group of hedge fund managers are buying or selling. So, if you can identify their asset-class exposures, you can replicate their performance characteristics using liquid proxies for those asset-class exposures. For us we use ETFs as the proxies for them and what we did in 2007 is, we launched these series of hedge fund-replication indexes that mirrored the performance characteristics of six of the largest hedge fund strategies, and those have been alive for almost five years. We use those as a building blocks for our various products like QAI, or MCRO or our mutual fund, IQHIX.

Horejs: OK. That's helpful for them. If you look at how the strategies have held up this year, what's something that you'd like to note?

Patti: Sure. I mean these products are designed to give you the risk/return characteristics of hedge fund investing without investing in hedge funds, so they are transparent, liquid, low-cost and tax-efficient. Today (Sept. 22) is a great example. I mean today the market was down almost 4%. QAI was down 0.6%, with about a fourth of the volatility of the S&P 500. CPI, which is another product that uses a very similar strategy, was actually up today. In August when the market was down 5%-6% QAI was down 0.5%, and CPI was up 1.5%. These are the tickers, CPI and QAI.

So, these products are now designed to shoot the lights out when the equity markets are going straight up. Investors have other asset classes to be in for that. What we're designed to do is, how do you lose less, because there are two ways to outperform their market: outperform on the upside or you can outperform on the downside, and if you're down 40% or 30% in the year, it's a lot harder for an equity manager to make that up for investors.

Horejs: We've definitely seen a strong demand for those types of products this year. Seeing as this is the ETF conference, I want to talk a bit about the three ETFs you offer, the IQ Hedge Multi-Strategy Tracker, ticker QAI; the IQ Hedge Macro Tracker, ticker MCRO; and IQ Hedge Merger Arbitrage, ticker MNA. So, how does that compare with your mutual fund product, the IQ Alpha Hedge Strategy fund, ticker IQHIX?

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Patti: Lot of letters there, you did a great job. Right, so QAI is a multistrategy product; it includes six hedge fund strategies like synthetic fund of funds-type strategy, which is very similar to the mutual fund and the mutual fund actually was just rated 5 stars by Morningstar, which we're extremely proud of. But QAI is really the ETF version of that. Macro is a global macro strategy, so it's a little higher-octane, a little higher-return, a little higher-volatility than QAI. And MNA is a merger-arbitrage strategy, which is really interesting for an ETF structure.

So, how do they compare and contrast? It really depends on what kind of investor you are. What we found is that people are using IQHIX. If you use both mutual funds and ETFs, you can use IQHIX in a nontaxable account and you can use a QAI or any of our other ETFs in a taxable account because they're more tax-efficient. QAI and macro for instance have never paid out a capital gain on portfolio turnover in their existence, which is tremendous tax alpha. They're also cheaper than mutual funds generally. Our mutual fund management fee is 95 basis points, and our ETFs are 75. So, its little more efficient on the tax side and a little cheaper, but mutual funds have their advantages as well for some investors.

Horejs: Beyond the tax efficiency and the costs, are there other factors that investors should look at if they're trying to decide whether to go to ETF or the mutual fund route for their portfolio?

Patti: Absolutely, and look everything we do is fully transparent. So, it's a little apples and oranges, but particularly in alternative strategies, one of the biggest drawbacks, beyond liquidity, is transparency. Not only transparency in terms of what the manager is doing to run this strategy, but what the manager is actually investing in, that is, what's in the portfolio? So, our products provide full transparency into what it is in the portfolio on a daily basis. We also have rulebooks right on our website. They are index-based products, and there is no K1s. And that really goes for either one of our products. So, I think ETFs generally, you should just make sure that you know what you’re buying; that’s really the more important thing. That really goes for any investment product.

Horejs: How much do you typically see investors allocating to a hedge fund-replication strategy like one of these?

Patti: It really depends, but we’ve seen a significant uptick during the last several years and interest generally in alternative strategies and hedge fund strategies. What we typically say is, use one of our products for 10% allocation. Let's say you’re using 20% of your alternatives bucket, put 10% in the QAI or an IQHIX or macro, and then if you have the skill and access, go out and find what you might think is an alpha manager and try to drive that alpha. This is because we’re providing you the exposure; we’re not going to provide you alpha. But that’s good; I mean we think that’s a good place to be. You don’t need to pay alpha fees for beta performance, and that’s what most people are really getting in hedge funds.

Horejs: Well, thanks so much for speaking with us today. It’s a very interesting concept, and I definitely appreciate your insight.